Passively managed index funds, and their close cousins, exchange-traded funds (“ETFs”)1, are garnering an increasingly large share of investor interest. They can offer several distinct advantages, including generally low fees and reasonable tax efficiency. However, a recent
Natixis survey of over 7,000 investors
found that respondents often credit these vehicles with attributes they are unlikely to deliver.
First, and perhaps most alarming, 60% of investors globally believe that index funds are “less risky.” (Also from our survey, we know that investors are most likely to define “risk” as not losing money.) This is closely related to the 60% who said passive strategies would “help them minimize losses.” Neither of these views however, is supported by theory or evidence.
Index funds are designed to track the market in which they are invested and fully replicate that return profile.Investors know that markets can have violent sell-offs, and indexes, by definition, are joined at the hip to those returns. So it’s unclear exactly why the respondents think index funds can limit losses. In contrast, actively managed funds have a couple of structural advantages in this regard. Active managers have the ability to position their portfolios defensively to mitigate losses. Unlike index funds, they are not obligated to follow the market down. (To be clear, actively managed funds could also be positioned more aggressively and incur larger losses than the index. The key point is that active managers have the opportunity to mitigate losses while broad market index funds and ETFs do not.)
Another important but more subtle factor is that actively managed funds tend to hold cash and other assets to meet redemptions and fund obligations, often around 3-5% of assets. This may give them a small systematic advantage over indexes during periods of steep losses.
Second, 61% of investors in the survey said that indexes offer better diversification.2 This of course depends on how you define “diversification.” As most indexes are spread across many securities, it is true that they can help reduce the risk associated with any one security. This is known as “idiosyncratic risk”. For example, because the S&P 500® is spread across roughly 500 stocks, none of those stocks in isolation is likely to take down your portfolio. However, this benefit may be of little consequence as it can be easily matched (or improved upon) by other strategies. In fact, the idiosyncratic risk we seek to avoid can be diversified out of an equity portfolio using as few as 20 to 30 stocks. After that number, idiosyncratic risk is fully diversified away. Given that most actively managed portfolios meet this standard (more than 20-30 stocks) it is hard to argue that indexes are more diversified.
Last, 55% of surveyed investors said that the indexes gave them “access to the best opportunities.” This is particularly curious given the way index funds are constructed. To maintain their liquidity, index funds and index ETFs invest in the most common and easily tradable securities representing a market. These tend to be the most well-known and well-researched companies – hardly the space to find untapped “opportunities.” Moreover, most of the largest equity indexes are market cap weighted, skewing their exposure to the stocks that have already been successful. (Similarly, the largest bond indexes skew their exposure to the issuers with the most debt outstanding.) Again, these would be curious places to look for opportunities. Conversely, active managers have the flexibility to look under rocks for less liquid, under- researched, or non-index securities where more alpha3 may potentially be found.
To be clear, index funds and ETFs offer tangible benefits for investors, including low expenses and tax efficiency. But it’s important to understand the limitations of passively managed investments. Investors looking to avoid losses, increase their opportunity set, or further diversify will likely find little help in the broad indexes. Given the strengths and weaknesses of these strategies, a truly durable and diversified portfolio must leverage the benefits of both active AND passive styles.
1 Exchange traded fund – An exchange traded fund, or ETF, is a marketable security that tracks an index. Unlike mutual funds, ETFs trade like a common stock on a stock exchange and experience price changes throughout the trading day as they are bought and sold.
2 Diversification does not guarantee a profit or protect against a loss.
3 Alpha – A measure of performance on a risk-adjusted basis, the term alpha refers to the excess return of the fund relative to the return of a benchmark index.
Indexes are unmanaged, do not incur fees, and include reinvestment of dividends and interest income, if any. It is not possible to invest in an index.
Source: Natixis Global Asset Management, Global Survey of Financial Advisors conducted by CoreData Research, June-July 2014. Survey included 1,800 financial advisors in 10 countries. Natixis Global Asset Management, Global Survey of Individual Investors conducted by CoreData Research, May 2014. Survey included 5,950 investors in 14 countries.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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